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What a downgrade by Moody’s would do to SA

We asked ETM Analytics MD George Glynos whether it’s possible to model the effect of a downgrade

11 July 2019 - 05:00 Giulietta Talevi

ETM Analytics MD George Glynos. Picture: SUPPLIED

A Moody’s downgrade is getting more probable by the day. But there’s no agreement about what would happen to the rand or our bonds if SA loses its investment-grade status and gets cut from the Citi world government bond index. We asked ETM Analytics MD George Glynos whether it’s possible to model the effect of a downgrade.

Anything’s possible, but the problem with models that are informed by assumptions upon assumptions is that you can get the thing to look whatever way you want it to. That’s exactly why I choose not to go down that road.

What rational assumptions can we make about what will happen if we drop out of the index?

There are going to be a set of investors who will be forced sellers because they are index trackers; that is a very simple, rational assumption.

What’s more disputable is whether the effect of that forced selling will ultimately be as negative as people say it might be. Therein lies the more interesting debate. Given how well SA’s fiscal problems have been telegraphed to the market, the risk of SA getting downgraded by Moody’s cannot possibly be described as a surprise. So a lot of people will be positioned for it.

You can have a hedge structure sitting on the sidelines that mitigates against the negative effect of some sort of gyration in the bond market. Or people may have already sold out of the index pre-emptively. But this belief that everybody will dive for the same small exit door at the same time just because SA has gone from investment grade to subinvestment grade — a lot of people have questioned that.

Remember, people are not forced buyers of the index. Investors are always trying to be one step ahead of the next guy. They’re not all going to be sitting on their hands just waiting to pull the trigger on a Moody’s downgrade. It just doesn’t happen that way.

What about junk bond investors?

Exactly. The idea that the forced sellers are automatically a much bigger portion of the market is questionable. How do you know whether demand from the subinvestment-grade market is not going to eclipse the forced selling that takes place from the investment-grade market? Just because you’re [a subinvestment-grade investor] doesn’t mean that your money is any less powerful than that of an investment-grade fund manager. One dollar is one dollar.

What makes a big difference is the number of people who might be licking their lips to get hold of SA paper. At the time, there are all sorts of factors that get taken into consideration. Let’s just say Moody’s downgrades SA and we’re in the middle of a global meltdown. The downgrade could then of course trigger a whole bunch of volatility in the rand, because you’re piling risk on top of risk. But if you get a downgrade in an environment where risk appetite is pretty healthy and there’s a big search for yield because, say, the US Fed has decided to go back to quantitative easing, well, you might find the effect is zero.

Was there any impact on the rand when we were included in the index?

If I had to ask you to look at where in that year SA got included, there’s almost no chance that, without knowing the date, you would be able to pick out when it happened. It looked like any other trading day, and, in fact, the trading range on the day of the announcement was one of the tighter ranges of the year. So why would there be such a huge impact on the expulsion from the index?

Would junk status have an influence on the buying decisions of the Public Investment Corp, for example?

Fund managers can invest in whatever bond market they want. So any opportunity to pick up SA bonds at an attractive price that would allow investors to achieve their inflation-plus mandates would probably be taken up by many.

Funds that are exposed to the index through their indexation processes can sell to the broader market, which is not beholden to any form of indexation.

Do you need a market maker in the event of a downgrade out of something like the index?

No, it’s essentially a free-for-all. But fixed-income market makers exist. You’d probably find that it’s not incumbent on Citi to manage the process; however, I suspect the bank would treat it as a golden opportunity to be able to broker deals between investment-and subinvestment-grade managers and it would probably make some money out of doing so.

"It’s disputable whether the effect of forced selling will be as negative as people say"